Bankruptcy Won't Work!

Wednesday, January 27, 2010

You’re at a board of directors meeting of your homeowners association. Things have been happening around the community―not good things―and you want to find out why. Why have they closed the pool? Why is the landscaping looking so bad? What’s with the rumor that the property manager might be let go. You know that money has been tight for the association. You’re aware that assessments haven’t gone up for years, and now word has it that a large number of owners have stopped paying altogether.

At the meeting the president of the association announces further cutbacks―the association’s insurance may have to be dropped. There have been no deposits to the reserve account for several years and, worse, the account has been drained over time to meet monthly obligations. The board proposes a 5% special assessment and approves it, but it’s not likely to go far with all there is to do and pay. A report from the manager confirms your worst fears: re-roofing of the project (including for your unit) will have to wait, and even temporary repairs to the leaking portions of the roof may not be done for months. There’s no money to pay for it.

A member raises his hand and asks the inevitable question―if the association is too broke to pay its bills, why not simply declare bankruptcy? Hold the creditors at bay until the economy picks up? No one on the board has a good answer. Why? Because it almost never happens. Here are the practical and legal reasons why.

No Big Creditors

The typical association has two principal financial obligations: its regular monthly operating expenses and contributions to its reserve fund for future maintenance and repairs. Vendors who provide regular services to a community association are typically paid monthly or are on limited annual or monthly contracts. This would include the landscaper, the pool service, management, and similar vendors. Any of these vendors can and will cancel further service if the association falls too far behind. So, unless there has been some major project, like re-construction or repair, the amount of any vendor’s outstanding invoice is not likely to get too high. And it is unlikely that any association would commence a major reconstruction project without having the funding for it in place. It is even more unlikely to find a willing contractor if the association can’t show that it can pay.

Ironically, it is not unusual to find that an association’s largest “creditor” is itself. The failure, year after year, to make reserve transfers creates unfunded liability and makes it impossible for the association to effect repairs when the time comes. Consistent with this creditor-as-self theory, the members who haven’t paid enough in assessments in the past now have only each other to look to for funds to pay to do the work now. Filing association bankruptcy wouldn’t relieve the association of the duty to make (and look to the members to pay for) repairs.

Another type of creditor might be someone who sues and wins a large judgment against the association. If the various insurance policies carried by the typical association remained in force, it is likely that they would cover such a claim. However, if it did not, this could be a substantial unplanned-for expense. It is an expense, however, that would survive any bankruptcy filing because of the ability to reach the assets of individual owners, as discussed below.

Another potential large creditor might be a bank making a loan to an association. The same impediments to bankruptcy would also be true of an association that borrows but then doesn’t repay. The lender would have the right to have a receiver appointed with authority to impose and collect assessments from the owners, to lien units and to file suit against individual owners who don’t pay their share. This is extremely unlikely to ever happen, however, since the lender would have carefully qualified the association and evaluated its and its members’ ability to repay the loan through assessments, before agreeing to extend credit in the first place.

The fact that some owners don’t pay their share of what their association owes to a creditor is not enough. That seeming shortfall becomes an internal debt to the association, which is in turn simply spread again across all owners in the form of assessment increases or emergency special assessments, until the creditor is paid in full. The ability of an association to pay its obligations is as deep as the combined equity of all property in the community and the assets of all of its members. This makes bankruptcy not a feasible option for associations.

The Reserve Fund as Financial Cushion

The association’s reserve fund for future repairs frequently acts as a cushion against a shortfall for monthly expenses. It shouldn’t be used that way[1], but it frequently is. Even if cash isn’t drawn from the reserve fund directly, the failure to contribute regularly to reserves because of underfunded assessments is just another way of subsidizing the monthly operating expense budget with reserves. Of course, many reserve funds have now been depleted because of either chronic underfunding or the recent economic downturn (or worse, both), so that source of financial support may not last much longer.

A corollary to the reserve fund supporting monthly operating expenses is that reserve expenditures don’t occur monthly, but arise slowly over time so they are easy to put off, allowing further support for the monthly operating expenses. The problem with this strategy is that the condition of various building components deteriorates further than they should when repairs are postponed, increasing the cost of the eventual repair and impacting unit values in the meanwhile.

Owner Pass-Through

But bankruptcies don’t typically occur with community associations for a big legal reason―owners are essentially liable for the association’s debts. “What?” you say. Community associations are corporations, and aren’t shareholders protected from corporate obligations? Isn’t that the whole point of a corporation?

Yes, most community associations are corporations―non profit mutual benefit corporations. But there is a major difference between a community association and the typical business corporation. With a typical corporation the investors’ (shareholders’) liability is limited to the amount of their individual investment. Community associations usually have something more―lien rights to an individual owner’s separate interest, either a lot or a unit, and the personal obligation of an individual owner for his or her share of assessments. So if an association assesses the members and someone doesn’t pay, the association has the authority to place a lien upon the individual’s property and enforce that lien for payment through the process of foreclosure and/or to sue the owner personally to collect the funds owed. The corporate structure of the association protects an individual owner from being solely responsible for the association’s total obligations, but not for his or her (or the lot or unit’s) share.

That authority, extended to the association by way of CC&Rs recorded against each individual’s lot or unit has the effect of “passing through” the association’s obligations to the owners. And to protect property from deterioration or lack of provisions for insurance, utilities, management, landscaping, amenities, etc., this obligation is buttressed by state law, perhaps not directly, but rather through the express requirement that every association must assess its members sufficient sums to pay its ongoing obligations. The California Civil Code contains the following language: “Except as provided in this section, the association shall levy regular and special assessments sufficient to perform its obligations under the governing documents and this title.”[2] We wrote about this provision in an article last year[3] and described a court case where the judge used the authority given to boards to levy emergency assessments and the owners’ obligation to pay assessments as grounds to charge individual owners for a debt of the corporation. The import of that case was and is that individual lot and unit owners are not insulated from the debts of the corporation.

A corporate bankruptcy filing essentially tells the world that the assets of the company are insufficient to meet its obligations to creditors. But, where the value of all of the real estate interests within the community can be accessed through the lien process to pay assessments, where assessments are backed by the personal assets of all owners, and where the association has a statutory obligation to assess, the property and personal assets of the owners essentially become the “assets of the company.” Collectively, these are likely to be more than adequate to pay any creditors.

For all of these reasons, a bankruptcy filing will not normally be considered a remedy available to a community association. There would have to be no equity available in property in the community, and each individual owner would have to file his or her own bankruptcy petition for that to be effective as against the association’s creditors. That’s simply not going to happen, or ever be a permanent situation. As owners walk away from property and mortgage holders take it back, the banks become responsible for the next round of assessment shares to pay the creditor. Lender foreclosures wipe out mortgages and create new market equity in property. Owner bankruptcies, even if pre-petition assessment debt is discharged, won’t address post-petition rounds of assessments for bad debt as they’re spread across all owners. Shares may slowly contract and debts can be negotiated, but the principle that the obligation is shared by all remains.

There are other remedies for an association that is overwhelmed with its financial obligations, and we have written about them in the past.[4] Nothing, however, substitutes for raising adequate income in the first place through steady, regular increases in assessments. There will be times, and we are now in them, when an economic downturn or other catastrophe can place an association’s financial condition in harm’s way. Unfortunately, if that should happen, it will fall on the owners to satisfy the debts of the community. Association bankruptcy is not a viable option.

If a community association gets to the point of considering something like bankruptcy, a different strategy is likely to emerge. When it can no longer pay its essential utility bills, or its insurance, or management, then questions of habitability arise. At that point the owners may need to consider a “partition” or sale of the entire property or perhaps a government takeover, strategies we have previously discussed.[5]

Boards and owners should be aware that there is probably no easy “escape hatch” through which a community association can pass to avoid failure. For many associations there is time to avoid that fate with sound financial management, an honest discussion with members about revenue needs, and a realistic funding plan.

(Sandra Bonato is a Principal at Berding|Weil)

[1] California Civil Code Section 1365.5(c)(1) states: “The board of directors shall not expend funds designated as reserve funds for any purpose other than the repair, restoration, replacement, or maintenance of, major components that the association is obligated to repair, restore, replace, or maintain and for which the reserve fund is established.” Temporary borrowing, however, is permitted (subject to significant procedural requirements, including disclosing a replenishment plan) and depositing adequate funds into the reserve fund in the first place is not mandatory.

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About Me

I received my Ph.D. in Government from Claremont Graduate School and my law degree from the University of California, Davis. Berding|Weil has represented community associations for over 35 years. For more information, please call 925-838-2090, or email: tberding@berding-weil.com